Second-Round Effects: Why Inflation Outlives Its Own Cause.

Economists call it second-round effects, and the fear of them is exactly why the ECB is tightening even as the war winds down.

A second-round effect is what happens when an initial price shock, like the rise in energy costs from the Iran war, stops being a one-off and starts spilling into other prices and into wages. The original cause can disappear completely, but the inflation keeps going, because by then it has spread into the wider system.

When energy gets more expensive, a delivery company pays more for fuel, so it charges shops more, so the shop raises its prices, so its workers ask for higher wages to keep up with the cost of living. Those higher wages let them keep spending at the new higher prices, but the employer has to raise their product prices to pay the higher wages.

To be clear, ECB President Christine Lagarde explicitly noted this week that officials see no evidence yet of these second-round effects taking a firm hold. So, the glitter hasn't permanently stained the carpet just yet.

However, Chief Economist Philip Lane pointed out that there is already “some momentum in wages,” with the average worker's pay likely to rise faster than inflation this year. Spain's Jose Luis Escrivá agreed, warning that these indirect effects are starting to become apparent as high oil prices feed into other areas of the economy.

That wage momentum is the early warning signal. A central bank can do very little about a war in the Middle East or the price of a barrel of oil. But it can act on potential second-round effects by raising rates to reduce spending before higher prices and higher wages start chasing each other in an endless loop.

So when you read that the ECB is hiking into a ceasefire, this is the true why. They aren't cleaning up a massive glitter spill that has already happened. Instead, they are stepping in with a preemptive vacuum to catch those stray flecks before they set into the wider system.